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Ch13: Commercial Bank Operations

Major Sources of Bank Funds: The principal source of funds for most banks is deposits accounts demand, savings, and time deposits. Economically, deposit accounts are similar to other sources of funds borrowed by the bank. Legally, however, deposits take precedence over other sources of funds in case of a bank failure. 1. Deposits (67% of total liability) 2. Borrowed Funds: Fed funds borrowed, securities sold under REPOs, etc. (18% of total liability) 3. Capital Notes and Bonds (1% of total liability) Major Uses of Bank Funds: Bank loans and leases are the primary business activity of a commercial bank, accounting for about 59% of all bank assets. 1) Loans and Lease Financing: Promissory notes, etc (59% of all assets) 2) Cash and Investments (4% and 17% of all assets) 5c s of Credit: 1) Character Credit history (willingness to pay). 2) Capacity Cash flow (Proforma Statements: What is going to happen to your balance sheet?) 3) Capital Wealth of borrower (What the borrower owns, such as: land, stocks, etc.) 4) Collateral Assets as security. Bank can liquidate if loan is not repaid (equipment, etc.) 5) Conditions Economic conditions that can affect the borrower (company) Credit Scoring: It is an efficient, inexpensive, and objective method for analyzing a potential borrower s character. A higher credit score indicates a lower risk of default. Most banks and financial institutions use credit scoring to analyze the character of borrowers in almost all consumer, residential real estate, and small business loans applications. One advantage of credit scoring is that it allows lender to make very fast loan decisions. The second advantage is that a person s credit score is based on objective criteria, which minimizes the potential for discriminatory lending practices. The disadvantage of credit scoring is that it is impersonal and does not allow for special circumstances. Also, the secretiveness behind credit-scoring models make it difficult for potential borrowers to improve their scores. According to Fair, Isaac, and Company (FICO), the following factors are ignored in their credit scoring model: Race, color, religion, nation of origin, sex, marital status, age, salary, occupation, title, employment history, etc. There are 5 factors involved: 1) Payment History (35%) Credit History (paying bills on time) 2) Amount Owed (30%) Relative to income 3) Length of Credit History (15%) 4) New Credit (10%) How recently you took the new debt 5) Types of Credit in Use (10%) Letter of Credit: A contractual agreement issued by a bank that involves three parties: Bank, Bank s customer, and Beneficiary. - In a commercial letter of credit, the bank guarantees payment for goods in a commercial transaction. The buyer of the goods arranges for the bank to pay the seller of the goods once the terms of the purchase agreements are satisfied. Commercial letter of credit represents only a small part of bank s off-balance sheet activities. - In a standby letter of credit (SLC), the bank promises to pay a third party in the event the bank s customer fails to perform according to a contract the customer has with the third party.

Call Loans) 3) Anticipated Income Theory: Started to make long-term loans and loans to households (mortgages. Call loans) Long -term loans . Harry Maulton says: Okay for banks to have open markets. It is the key ratio in evaluating the quality of bank management.V. ASSETS: LIABILITIES & EQUITY: Short term. In practice. banks obtain liquidity from both sides of the balance sheet. only to companies (commercial). Allows the comparison of one bank with another. Self-Liquidating Loans Given" Open market assets (T-bills. Prochnaw: Any bank loans are made on basis of anticipated income of the borrower. Banks can fail in two ways: 1) Solvency A bank can become insolvent by suffering losses on its loans or investment portfolio (credit risk or interest risk). o Rail Road Industry Self liquidating because in case of default. o No loans to households.Ch14: Bank Management and Profitability Measures of Profitability: 2 ways: 1) Rate of Return on Average Assets (ROAA): Calculated as. ASSETS: Short term. 2) Liability management: Acquiring liquidity from the liability side of the balance sheet. Net Income / Average Equity Capital. their ROAEs are quite respectable even though their ROAAs are very low. 2) Adequate Liquidity A bank can be a profitable business operation but fail because it cannot meet the liquidity demands of its depositors or borrowers (liquidity risk). Theories of Profitability: There are 4 theories: 1) Commercial Loans Theory (Real bills Doctrine. because it tells how much profit bank management can generate with a given amount of assets. resulting in a depletion of its capital. It tells the bank owners how management has performed on their behalf (the amount of profits in relation to their capital contribution to the firm). Self-Liquidating Loans Open market assets (T-bills. o H. Because banks are very highly leveraged (low capital-to-assets ratios). but not really. self-liquidating loans LIABILITIES & EQUITY: Given" 2) Shift ability Theory (1930s): Banks being acceptors of liability. of courses. 2) Return on Average Equity (ROAE): Calculated as. they can sell the trains. o Roll-over-loans It is like long-term loan. ASSETS: Short term. 1770s 1920s): Bank should only make short-term (less than 1 year). Bank Failures Inadequate Liquidity Bank Profitability Bank Failures Bad loans or investments Adequate Liquidity Solvency There are two approaches to managing liquidity risk: 1) Asset Management: Relying on our available cash and sellable assets to meet demands for liquidity. selfliquidating loans. Net Income / Average Total Assets. New loans every year because banks only lent short-term loans (EX: rail road industry is long term and they had to take new loans every year until completion of the projects). etc).

2) Tier 2 Capital (supplemental capital) Includes cumulative perpetual preferred stocks. Ch15: International Banking Reasons for Growth in International Banking: 4 Reasons: 1) Increase in International trade 2) Growth of Multi-National Corporations: Companies needed more loans overseas. To make presence in the international scene. 3) Edge Act Corporations No reserve requirement (or low). retained earnings. mandatory convertible debt instruments.Loans to Consumers LIABILITIES & EQUITY: Given" 4) Liability Management Theory (late 1950s early 1960s): Started to advertise for deposits (radio. Special privileges for international trade purposes. Also helps establish bank recognition. They attract business. loans loss reserves. 6) Correspondent Banks Don t take deposits or make loans. newspapers. Self-Liquidating Loans Open market assets (T-bills. They cannot make loans or take deposits. and minority interest in consolidated subsidiaries minus goodwill and other intangible assets.). They can talk (not provide) about services of parent bank. 2) Representative Offices Main job is to attract loan customers for the parent bank to lend. They act as an intermediate. 4) Foreign Subsidiaries & Their Affiliates Name recognition. and other debt instruments that combine both debt and equity features. paid-in surplus. However. they can t lend. International Banking Facilities (arrangements): 1) Shell Branches Located on islands. Documents Involved: 1) Accept Bank Drafts 2) Honor Letters of Credit 7) Foreign Branches They have to be subject to U. There is no contact with the public (phone and internet). We need more financing. regulations and host country regulation. . 5) International banking Facilities Computerizes accounts (way to keep track of flow of funds). etc) to increase liquidity through sources of funds. 4) Increasing Oil Prices: Oil embargoes (1973. More international lending.S.S. but can t do the job themselves. Call loans) Long -term loans Loans to Consumers LIABILITIES & EQUITY: Demand Deposits Savings Deposits Time Deposits Capital Adequacy Regulation: Current capital adequacy requirements in the United States define two forms of capital: 1) Tier 1 Capital (core capital) Includes the sum of common stock. ASSETS: Short term. Agreement Corporations: Had to meet capital requirements. 1978). noncumulative perpetual preferred stock. These facilities have to be located in the country (U. There is a contact person with public. 3) Encouragement by Bank Regulation: Less regulation for banks that collected funds from the other countries. subordinated debt instruments.

It is rated on a scale from 1 to 5. Purchase Assumption Agreement: The government and FDIC work together (give money). E Earnings L Liquidity: Near Cash that you can liquidate.Banks ignored slam savings families before . people won t care about risks and they will count on the insurance. C Capital Adequacy (tier 1 and tier 2 capital) A Asset Quality: Look at your loans M Management: Look at probability ratios (ROAA. (fastest growing in many states). In 1970s. The government pays off all the liabilities and liquidates all of the assets. their cost of funds rose quickly above interest rate earned on mortgages. 3) Residential Bond (10%) You have to be a resident of a State. 2) On-Site Examinations Unannounced. Credit Unions: It was created to serve low income families.Early 1980s: interest rates increased sharply. the lower. affordable credit) Common Bonds of Credit Unions: 1) Occupational Bond (80%) You are part of a common union. which resulted in a negative net interest margin. Long-term rates were higher than short-term rates. Help stronger institutions purchase the ones failed. Bank examiners come and analyze your balance sheet. 2) Too Big to Fail (TBTF): Domino effect. S&Ls borrow short-term. Letting one institution fail can let many other related institutions to fail. group member. it became easier to become a member. 2 Ways to Examine: 1) Call Reports Quarterly. Since S&Ls sold short-term deposits to lend long-term (mortgages). exchange rates. Not Taxed! . the better. It is more costly than purchase assumption agreement. plumber s union (you have to have an association). They analyze how many problem loans you have. ROAE). .Ch16: Regulation of Financial Institutions Payoff and Liquidate: Pays off its deposits when banks fail (FDIC protects depositors). County. resulting in a positive net interest margin. . Issues in Depository Institutions: 1) Moral Hazard: When you tell everybody that they are protected (insured). etc.Better way to treat customers (high rates. Banking Examination Process: Today. CAMELS Rating System: Used to evaluate bank performance. It is cheaper than pay than off and liquidate approach. etc. Statement of conditions (portfolio of loans).Late 1970s: High inflation rates. City. They will take more risks. . all commercial banks in the United States are examined by a bank regulatory agency (federal or state).To provide an outlet for their savings . 2) Association Bond (10%) Church member. Examinations are more frequent if a bank is believed to be particularly risky. S Sensitivity: Analyze the sensitivity (ARMs) of changes in interest rates. S&L institutions net interest margin shrank to almost nothing. Ch17: Thrift Institutions and Finance Companies Balance Sheet of Savings Institutions: Assets: 1) Loans and Leases (73%): 1-4 family residential (50%) 2) Securities (17%) 3) Cash and Due from Depository Institutions (2%) Liabilities and Equities: 1) Deposits (58%) 2) Borrowed Funds (28%): Fed Funds and REPOs Shift on Yield Curve and Interest Rate Squeeze That S&Ls Faced: In the Late 1970s and early 1980s.

4%) Balance Sheet of Property/Liability Insurance Companies: Assets: 1) Bonds (56. you can take (transfer) the pension fund. 3) Reciprocals Each member is insuring the other member. The net returns on home equity loans were higher than net return on other loans. 4) Second mortgage for most part still had tax-deductible status (benefit for the poor people). Ch19: Investment Banking 3 Steps of investment banking process (of underwriting): 1) Origination Asks the company: why the need of money o Stock or Debt Security? o File requirement statement with SEC (takes few weeks) o Shelf Registration: You have 2 years period to offer securities without having to go to SEC 2) Underwriting (Risk Bearing) Inventory Risk (inventory of stocks). It is like vesting but this would happen after years for example. 2) Stock Company The Company is owned by stockholders.5%) 2) Unearned Premiums (14%) Pension Funds: There are Public (social security and social adequacy) and Private Pension Plans (employment benefits).6%) Liabilities and Equities: 1) Policy Reserves Liability (46.4%) 3) Premium Balances (11. Ch18: Insurance Companies and Pension Funds 4 Types of Insurance Organizations: 1) Mutual Form (Mutual Companies) The Company is owned by the policy holder. 3) Funded Plans Funds come from employer and individuals. 2) Portability Once you leave the company. there was a growth in home equity loans secured by a second mortgage.3%) 2) Mortgages (6. For Private Pension: 1) Vesting After a period of time.9%) Liabilities and Equities: 1) Losses and loss adjustment expenses (38.8%) 2) Corporate Stocks (11. o Syndicate formed to share risks of IPO o Investment bankers guarantee to buy the securities and sell to the public 3) Sales and Distribution Sales and distributes o Easier to sell bonds than stocks o Bonds sold in huge blocks to institutional investors. 4) Lloyds Association Insures famous people. . Balance Sheet of Life Insurance Companies: Assets: Consists of mostly long term loans 1) Bonds (49. a company will contribute to the pension fund (so the employee is settled).Growth of Second Mortgage Landings of Finance Companies: In 1980s. The growth was caused by: 1) Inflation increased demand for loans and the equity in homes 2) Good source of collateral 3) They were making larger and longer-term loans (10 15 years).2%) 2) Separate Account Business (32.